Happy Birthday, Adam Smith!

June 16, 1723, is the birth date of Adam Smith, a Scottish intellectual greatly admired for clarifying the virtuous, self-organizing nature of free markets. Smith noted that humans’ evolved self-interest trait encouraged people to seek wealth-creating exchanges. That was the key element of his famous work The Wealth of Nations. But Smith also realized that such exchanges require that each party have some knowledge of what the other party seeks and what it would view as a fair deal. And that realization led Smith, in his book The Theory of Moral Sentiments, to focus on another human trait, empathy. This is the social skill that we all possess to varying degrees to get inside the mind of the other, to understand what they value. This trait is equally critical if markets are to exist and wealth creation is to occur.

British twenty-pound note featuring Adam Smith.

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Self-interest encourages deal-making and empathy makes it more likely that such deals will be fair—and, thus, more likely to be repeated. Smith recognized that free markets were the result of the creative synthesis of these two traits. Too few capitalist defenders today realize that understanding both traits is critical.

Self-interest provides a direction and compass, helping individuals determine which actions are most likely to advance their goals and increase their profits. We always a myriad of choices, and self-interest provides a way of picking from among them the path more likely to result in success.

Empathy deals with our awareness of how others will react to our actions and our choices. It permits us to get into the skin of another person and understand, to some extent, their motives and values. These dual traits distinguish mankind from other social animals. Animals, too, are self-interested and sometimes cooperate. But, as Smith notes, they don’t bargain—they lack the empathetic traits that would allow them to know what the other wants and reach a mutual win/win agreement. Smith notes: “Man is an animal that makes bargains: no other animal does this—no dog exchanges bones with another.”

Long after Adam Smith’s time, another great economist, Ronald Coase, expanded on some of these observations. He noted that any bargain—any exchange—requires overcoming a number of challenges: how do I know what others have to offer? How do I estimate what (and how much) they want in exchange? How should I handle the bargaining process? Self-interest drives people to seek deals; empathy allows one to surmount the challenges, reducing transaction costs.

Most people know Smith as the defender of free markets, free enterprise, and capitalism—and, indeed, he was that. But most focus only on The Wealth of Nations, the book that explains the wealth creation potential of voluntary exchange. There he explains the market’s self-organizing potential (spontaneous order) by the example of a pin factory. Someone organizes a set of tasks, acquires specialized equipment for these tasks, and then employs people to perform the tasks. Smith demonstrated how rational capitalism (the self-interest trait) achieved greater wealth creation via specialization and division of labor. He noted that one individual seeking to do all the tasks himself might make a few hundred pins a day, but a team each performing one task could produce tens of thousands.

Smith was writing at the dawn of the Industrial Revolution, before modern corporations. The pin factory he discussed was a transitional institution, in which the loyalty of the workers reflected the earlier feudal duties that a peasant owed to the lord or the monastery.

But as capitalism’s rational nature weakened such feudal loyalties, managers had to become more than mere taskmasters. Capitalists had to find ways of ensuring a positive working environment. Employees, after all, are not serfs. They can and may well quit, moving onto to jobs offering greater satisfaction. Thus, successful managers must seek a win/win cooperative relationship with their employees (and their customers, suppliers, and investors). That challenge requires attention to self-interest, like encouraging greater productivity and efficiency, but also to empathy, ensuring that the concerns of these cooperators are met as well. The firm itself also operates in a competitive environment. Failure to achieve these cooperative results is indicated by losses of customers, higher turnover of employees, less responsive suppliers, and fewer investors.

Smith may well not have foreseen how the firm would become a training ground for inculcating both the efficiency-enhancing traits of self-interest and empathetic outreach traits. Nor did he likely realize fully how the benefits of such cooperative win/win arrangements would carry over into non-economic aspects of life, strengthening civil society. But Smith did point the way to that glorious future, the virtues and values of what economist Deirdre McCloskey and others have labeled “doux” (meaning gentle or sweet) commerce.

Historical note: Adam Smith’s birth date is sometimes listed as June 5, 1723, due to the change from “Old Style” to “New Style” dates in the 18th Century, when the United Kingdom switched from observing the Julian calendar to using the Gregorian calendar in September 1752. June 16th is the “New Style” date.